BenCarlson

There are generally two reasons for a given investment strategy to “work” over time:

You earn a premium by accepting more risk.

You take advantage of the behavior of other market participants.

If I put my rational, textbook theory cap on, number one should make sense. But there’s always a human element to the markets so the behavioral explanation always make more sense to me when trying to determine the probability of something working in the future. Knowledge alone is never enough to change people’s behavior, so to some extent there will always be irrational happenings in the markets.

It’s safe to say that any historical market anomalies — value, momentum, quality, low volatility, etc. — are likely explained by both risk and behavior, but my sense is that irrational behavior is what will keep them going in the future, even if they’re not as effective as they were in the past.

Value, as discussed previously, is driven by an overreaction problem, in which humans are too quick to draw conclusions from a small amount of recent data. In contrast, momentum is driven by an underreaction issue, which is the opposite of overreaction. With underreaction humans are slow to update their views based on new evidence, which could be due to a systematic behavior bias and/or due to the fact human beings simply have limited cognitive power (i.e., “limited attention” as it is called in academic literature).

At first glance it almost doesn’t seem to make sense that both value and momentum could be caused by irrational investor behavior because they are diametrically opposite investment strategies. How can we explain both overreaction and underreaction in the same marketplace?

Wes and Jack explore this paradox through the old frog-in-a-pot theory. The story goes that if a frog is placed in a boiling pot of water it will immediately jump out. But if you place it in a room temperature pot of water and slowly increase the temperature to boiling point it will sit in there until fully cooked. Here’s how this fits with academic research on investing:

Interestingly enough, research has found that the frog’s reaction to gradual temperature changes is analogous to how investors react to gradual stock price changes. For example, if a stock has an immediate 100% gain (i.e., dropping the frog in a pot of boiling water), the strong price will typically reflect approximately fair value. However, if a stock gradually grinds along and achieves a 100 percent return (i.e., the water slowly heats up over time), investors will pay less attention to the gradual stock price movement and the security will likely be priced at less than fundamental value. In psychological terms, both the frog and human investors suffer from “limited attention,” which simply reflects the idea that our cognitive resources are limited and our brains will focus processing the information that is most relevant at a given point in time. Determining what is “most relevant” turns out to be a challenging question. Psychological research, however, has found that dramatic changes in an environment, as opposed to small changes, attract more cognitive resources, all else being equal.

Researchers conclude that gradual changes attract much less attention than dramatic changes. So investors typically underreact to gradual information but overreact to dramatic changes in the markets.

The theory behind both momentum and value investing is that investors first underreact to news, events or data releases but then overreact once things become more apparent. When investors get caught up in the herd mentality, this causes stock prices to overshoot in both directions. So undervalued stocks can drop further than fundamentals would dictate while overvalued stocks can rise further than fundamentals would dictate.

The question some investors may ask is this: Isn’t momentum investing just performance chasing?

In a way it is, but not necessarily in the harmful way most investors practice it. Momentum tends to work with a 3-12 month look-back period and has to be rebalanced frequently to work effectively. Most momentum strategies look at the best performing stocks over the previously three-, six- or 12-month periods with the expectation that this performance will continue.

Research shows that a 12-month look back is usually the best performer, but the effects are not long-lasting. Momentum is not a buy-and-hold strategy; it’s a buy and continuously rebalance strategy (typically monthly or quarterly for most systematic strategies, but some can make changes even more frequently) because momentum never lasts forever when investors finally wise up.

While momentum basically makes an implicit bet against short-term mean reversion, value investing is on the other end of the spectrum and makes a bet on long-term mean reversion. The problem is that most investors tend to use momentum (performance chasing) but at a value investing time horizon. So they get the worst of both worlds.

The interesting thing about these two strategies is how well they complement one another since they have such different attributes.

I’ve only scratched the surface here so if you’re interested in more of a deep dive you should check out Wes and Jack’s new book. It’s really well done and full of both quantitative and qualitative reasoning behind both strategies.

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